Credit risk: definition, types and assessment

What is credit risk?

Credit risk is similar to the potential losses that a bank incurs when it lends money to an economic agent. If the debtor, whether he is an individual or a company, has not paid back his debt when it is due, the bank will lose part of the funds that it lends on a payment basis. The importance of credit risk depends on 3 main parameters:

  • the amount of the debt,
  • the probability of default,
  • the proportion of non-recovery in case of default by the debtor.

Operational risk: definition, types and problems

Types of credit risk

The credit market is a financial market of gigantic size. It groups several types of loans: direct loans granted by banks, bond credits and counterparty risks generated by transactions in derivatives (forward, future, to exchange, etc.).

Remember: derivatives are financial instruments based on underlying transferable values ​​or market indices.

Credit risk is not fixed over time, but can evolve according to different parameters that can affect the solvency of the debtor (individual or company). The assessment of credit risk depends on elements internal to the company, but also on contextual factors. Among the main risks, economists distinguish:

Operational risk: it results from the bank’s inability to assess the credit risks to which it may be exposed after an internal default or exogenous events.

LLiquidity risk: the debtor is in a situation of illiquidity that does not allow him to honor his debt. This situation, temporary or permanent, can result from a bankruptcy filing, a sector crisis, etc.

Sovereign risk: it manifests itself when a State stops or reverses the convertibility of its national currency. Actually, this risk is particularly difficult to predict. Likewise, a political change can affect interest rates and alter the financial return of funds lent by investors.

Credit risk assessment

Prudential regulation imposes strict restrictions on banks in managing their risks and allocating capital.

Credit risk is related to the quality of the loan. To identify, banks assess the risk attached to each of their customers and the overall risk of their loan portfolio. In practice, when an individual or a SME/SME comes to knock on the door of a bank, the risk it represents is assessed based on the analysis of the credit file and mitigated by taking guarantees. Risk control also involves the calibration of credit lines granted. When it comes to financing for large companies, the assessment that credit agencies give to these companies based on their financial strength and their future prospects allows investors to better assess the credit risk.

As each transaction modifies the bank’s risk exposure, the risks are assessed at group level (consolidation). The calculation of the global exposure takes into account both the nature of the transactions (balance sheet / off balance sheet) and the maturity of the loans.

Remember: the off-balance sheet includes commitments made or received that do not give rise to a budget entry. Among them, we can find contractual commitments, etc.

Credit risk: hedging products

Credit derivatives are financial products that give banks and companies the possibility to manage the counterparty risk of their loan or loan portfolios. These products are useful to cover credit risk, the bank seeking protection sells all or part of the risk to an investor ready to assume it in exchange for a remuneration as, for example, with securitization.

Among these products, credit default swaps (CDS) in particular gives the possibility to transfer the default risk of a credit subject to other financial agents, the sellers of protection.

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